November 2010 – Day 3: Arizona Police and Fire Pension

Fearing a potential exodus of police officers and firefighters eligible to retire, the Arizona Legislature a decade ago created the Deferred Retirement Option Plan as a way to keep experienced public safety officers on the job.

The deal seemed simple: If officers agreed to work up to five extra years before retiring, the DROP program would pay them a lump sum in addition to their annual pension when they finally retired.

The program remains enticing. Today, participants’ lump-sum payments at retirement average $268,938 for all public-safety officers. The average payment for police officers is $247,422, and $314,338 for retiring firefighters.

Officers enrolled in DROP also draw their annual pensions once they step off the job.

The lump-sum payouts, combined with cost-of-living increases that have outpaced inflation and multiple years of investment losses, caused taxpayers’ costs for the program to soar.

As a result, the Public Safety Personnel Retirement System is so underfunded that even its top administrator says the overall pension program needs to be changed, perhaps drastically, to stem the expanding public subsidy.

“The plan is upside down,” said Jim Hacking, its director. “It’s not reasonable or realistic for our constituent groups or anybody to say, ‘We will not do anything.’ It’s not a rational response.”

As DROP was rolled out during the past decade, public-safety retirees received cost-of-living adjustments to their primary plan, and average annual pension benefits grew to $44,025 – the highest among all Arizona public pension systems.

The public’s tab through employer contributions for the combined pensions, cost-of-living increases and DROP payouts in the past decade has grown from $46.8 million to $316.2 million a year – a spike of nearly 576 percent, or 22 times more the rate of inflation during the same period. Those increasing costs mirror the growth in Arizona’s five other public-pension systems. An Arizona Republic investigation has found the pension systems are costing taxpayers at least $1.39 billion a year – more than the current state budgets for higher education, corrections or a health-insurance program for the poor.

Byron Schlomach, an economist with the Goldwater Institute and a critic of the state’s pension systems, said the public-safety benefits are overly generous and the burden for taxpayers was unreal.

“It’s nice they have figured out a way to rob us,” said Schlomach. “This is ridiculous. How can anybody justify this?”

Hacking said there was “no question DROP added some liabilities” to the public-safety pension trust, but he believes the system has been hurt more by investment losses at the beginning and end of the last decade due to stock market conditions, and by guaranteed cost-of-living increases to retirees.

Supporters of DROP say it has helped police and fire departments retain experienced talent while allowing municipalities to better plan when to add staff.

“Police officers were leaving as soon as they were eligible to retire,” said Jim Mann, executive director of the 6,500-member Fraternal Order of Police. “There’s a real need to keep experienced officers on the job because it costs so much to train new officers.”

Tim Hill, president of the Professional Fire Fighters of Arizona, which also has 6,500 members, said the lump-sum payments were misleading. While they sound high, he contends the program saves the pension system money in the long run. He said once public safety officers opt into DROP, they no longer continue to accrue credits for their years of service. By comparison, he said, officers who remain a full 25 years or more and do not take part in DROP have their pensions calculated based on total years of service, giving them larger pensions that, over time, may eclipse DROP’s upfront cost.

Neither employee organizations nor the pension system could provide precise estimates of whether DROP has been a net expense or savings for the pension system. However, around the same time the public-safety system instituted DROP, the Arizona State Retirement System, the largest public pension program, rejected the same program because its director said it was too costly.

While the payouts are rich, participation in DROP in recent years has fallen after steadily growing from 2002 to 2006, when a record-high 1,746 members were enrolled. Last year, participation fell to 1,044, or roughly 5 percent of the total active membership in the pension program.

Hacking said enrollment fell because in the past few years there have been fewer employees with the required 20 years of service to enter the program.

How it works

The Public Safety Personnel Retirement System allows its members to enter DROP after 20 years of service. They then must remain with their employer for up to five more years, and during that time neither the employee nor employer contributes to the retirement system.

Upon entering DROP, the employee’s pension is calculated based on years of service up to that point and the highest consecutive three years of compensation. The amount the employee would have received in a pension is essentially set aside by the public-safety pension system, and the money is guaranteed to increase at the trust’s assumed rate of growth, currently 8.25 percent.

The DROP payments are higher for those who come into the program with a larger salary and more years of service.

By law, the interest is paid even if the assumed rate doesn’t materialize. That means there’s no risk to the employee, but it’s a big problem for taxpayers when the stock market drops, which caused negative returns for the trust in 2001, 2002, 2008 and 2009. When the system loses money, employers using tax dollars have to pay more to make up the losses.

Anthony Webb, an economist at the Center for Retirement Research at Boston College, said the guaranteed growth rate for DROP participants is unheard-of in the private sector unless money is placed in high-risk investments, but even then, there are no guarantees.

Hacking said the interest rate is set by state law, and he said the pension system is well diversified and not dependent on high-risk investments.

Along with the DROP benefit, participants have other benefits unique to public-safety personnel. Because of the recognized physical stresses of police and firefighting jobs, and the dangers of being killed on the job, public-safety pension systems generally have allowed participants to retire earlier than those in the private sector.

The average age for public safety retirees is 50.8 years, and the pension continues until a person dies. At that point, a spouse receives 80 percent of the pension until that person dies and the pension payments stop.

Benefits for DROP participants skyrocketed in 2007, when some of the first participants left the program and collected payouts after participating for the maximum five years.

That year, DROP benefits totaled $151.9 million, a 566 percent increase from the previous year when $22.8 million was paid. In 2007, DROP accounted for one-third of all pension benefits paid to police and firefighters. The previous year, it accounted for just 8 percent of all benefits.

DROP payments declined to $98 million and $91 million, respectively, in the past two years. But they still accounted for roughly 21 percent of all pension benefits for 2008 and 2009.

‘Unsustainable’

A consequence of the large payouts and diminished investment earnings is that the pension trust currently is funded at just 65.8 percent, the lowest among the six public pension systems in Arizona.

That means the money now in the trust would pay for only 65.8 percent of the system’s current liabilities if they all came due at the same time.

The goal is to be 100 percent funded; 80 percent is considered healthy by industry standards.

The closer a pension is to being fully funded, the lower the contribution rates for members and their employers.

Arizona law sets trust contributions by police and firefighters at 7.65 percent of their wages. If investment returns are poor and the trust is underfunded, the employee contribution is not raised.

Instead, any shortfall is generally made up by employers through tax dollars, though the trust also is partly funded through taxes on homeowner-insurance policies.

Employers currently contribute an amount equivalent to nearly 21 percent of an employee’s gross wages. That’s roughly four times the rate 10 years ago.

But Mann, of the Fraternal Order of Police, countered that while employer contribution rates may be high now, there were times when police officers and firefighters paid higher rates than their employers. When employers had lower rates, he noted, they were not asking to pay more to make it equitable.

Employer rates are projected to rise to 37.5 percent by 2024 in order to make up for the system’s current indebtedness.

One reason for the increase: cost-of-living raises have been given to public-safety pensioners for 24 consecutive years.

In 2009, each retiree received an additional $1,761, a flat amount calculated on the average pension.

Hacking said the current overall program was “unsustainable,” and he said he would work with employees and employers to propose changes to the Legislature next year.

He declined to disclose specific reforms, but he said it was possible DROP “will not look like the one we have now.”